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Question of the Week - July 28, 2014

Question of the Week - July 28, 2014

Guest Post - Monday, July 28, 2014

What's going on with Argentinian bonds? How will the recently released changes for money market funds affect clients?

We have to take a step back at least a decade to understand the unusual set of circumstances that surrounds Argentina's possible upcoming default. This started from their original default of $100 billion worth of debt in 2001-02, which followed IMF-imposed austerity measures, severe economic hardship and some poor political choices. With difficult access to credit markets, the government spent time and effort to devalue their currency, the peso, to further erode the existing peso-denominated debt (note that such efforts would have made USD-denominated debt repayment even more precarious, but they'd already defaulted, so a moot point). This didn't help their international reputation at the time, and trust is still hard to come by.

Interestingly, after the default, Argentina grew a bit faster than many predicted, and offered the original bondholders about a third of face value in 2005 to settle their defaulted debt (as well as a 'kicker' option to participate in any GDP gains). In the next several years, 80-90% of creditors reached some type of negotiated settlement to accept the deal, leaving a few holdouts consisting largely of U.S. 'distressed debt' hedge funds, who bought cheap notes at pennies-on-the-dollar prices in hopes of large profits if they could hold out long enough to push for a better deal. Uncertainties there include not only the time involved, willingness of the Argentinian government to settle at a higher value than it did for earlier creditors, and political pressure this hedge fund group (called the 'vultures') was able to apply to U.S. legislators to force Argentina's hand. Then, the case went to court with the hedge funds as plaintiffs–who attempted a block of the Argentinian government's offer to again exchange these for lower-valued bonds; instead, the funds are insisting on full repayment of the original principal. This all has the makings of a true fixed income soap opera.

A few years ago, a New York appeals court ruled against Argentina, ordering that the $1.33 billion in bonds be paid in full by an upcoming deadline (Thurs., July 31), and if they didn't, blocking U.S. banks from transferring funds to other creditors until the issue is resolved–effectively, causing a technical default due to lack of operational ability to transfer coupon payments. Last week, a Federal judge ordered around-the-clock negotiations aimed at avoiding the second default, but the weekend passed with no one budging on either side. While Argentina is in better shape than it was at that time, officials remain combative and unwilling to bend. Although Argentina may be a special case, it also may set a unique precedent, as well as potentially cast a negative shadow on the willingness of some nations to issue debt through U.S. banks. Other financial centers, particularly London, have already taken significant global market share in recent years and unfavorable rulings might not help.

It's a unique situation, but something Argentina has brought on through a pattern of political turmoil, poor decisions and subsequent financial repercussions. In this case, if referencing the 'C's' of bond credit research, it went beyond the usual element of 'capacity' into one of 'character,' which is usually less common of a problem. It shouldn't be a surprise that the nation has been downgraded from emerging down to 'frontier' market status (on par with far less-developed nations) and proves again that once yields get wide enough, someone will buy your bonds. All parties involved just have to be ready for the roller coaster that might be waiting.

How will the recently released changes for money market funds affect clients?

We don't talk about cash much (especially with rates as low as 0.01%), but the SEC has finished their evaluation and come out with more formalized rules about how money market funds will operate going forward. In a nutshell, money funds used by institutional investors and owning corporate/muni paper (known as 'prime' funds) will be subject to a floating market-based NAV instead of the traditional $1/share book value pricing. An important exception, though, is that all retail and all government/treasury funds, retail and institutional, will continue to be subject to the $1 NAV convention. Also, funds will now have the ability to impose redemption fees and delay the settlement of redemption proceeds under times of extraordinary financial system stress. This outcome wasn't unexpected and is a bit watered-down from the original proposal two years ago that called for floating NAVs on all money market funds–this wasn't a popular idea, as it would be more difficult to implement on a widespread basis and imposed a larger tax reporting burden on the public (imagine a catalog of all capital gains/losses if buying at $0.98/share and selling at $1.01 and vice versa for millions of investors).

This whole idea was meant to provide additional stability to a segment that suffered from investor runs and consequent 'breaking the buck' events during the financial crisis. The financial industry seems happy with the change, since they've had two years to get used to the idea that things would change somehow; on the opposite side, consumer protection advocates were hoping for even more safeguards. Regardless, this will take some time to work through over the next few years, updating computer systems and investor expectations. Despite a name similar to the FDIC-insured money market bank account, the money market mutual fund has never been a guaranteed free lunch, although it's traditionally been treated that way by Main Street.

What else could happen? There are significant assets in this segment of the bond market, and money funds are significant buyers of corporate prime paper; although, at the same time, due to changes in bank liquidity rules, supply of this type of paper has fallen as well, so this impact might be more muted than previously thought. With yields as low as they've been for several years (too low to absorb normal fees), many money funds have been merged together or closed outright. At the same time, due to the new rules, demand for short government debt could well increase, so credit spreads may diverge again as they have at times in the past. There is time to digest all this, and by that time, perhaps money market yields will be high enough to be worth caring about.

Additional Reading

Read our Weekly Review for July 28, 2014.

Read the previous Question of the Week, July 14, 2014.

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